The bankruptcy code provides exemptions to repo and derivative dealers and this carve out led in part to the 2008 financial crisis.
That provocative statement was made at a hearing of the House Financial Services Committee when that body debated the Financial CHOICE Act, a proposed bill which would largely repeal the Dodd/Frank Act passed in 2010.
“the core idea behind the Chapter 11 bankruptcy process that is open to non-financial firms is that those proceedings will create an orderly wind down of the company, enabling the distressed firm to remain in business and pay its creditors what they are owed over time in an equitable and orderly manner,” said Dr. Norbert Michel, an analyst with the right leaning think tank The Heritage Foundation. “These safe harbors from core bankruptcy provisions distorted financial markets leading up to the 2008 crisis because they gave derivative and repo users preferred positions relative to other types of creditors.”
Dr. Michel argued that bankruptcy code provides for an orderly winding down of the company and an orderly payment of its debtors, which he argued, is exactly what is necessary for firms which have the kind of systemic risks that banks have.
Dr. Michel stated that the 2005 law, the Bankruptcy Abuse Prevention and Consumer Protection Act, essentially made all mortgage backed securities into repos and as a result, all repos and derivatives dealers enjoyed carve outs from bankruptcy.
“Proponents of these special exemptions have argued that safe harbors allow counterparties to quickly cancel contracts and enter new hedges (with other counterparties), thus ensuring their financial health and avoiding financial market distress.” He said.
But Dr. Michel argued: “There has never been a clear economic reason that this process would create systemic problems if it were open to financial firms, and a main problem with the pre- 2008 crisis framework was that the bankruptcy code included special exemptions (safe harbors) for derivatives and repurchase agreements (repos),” Dr. Michel stated. “As a result, starting in 2005, any derivative or repo user enjoyed safe harbors from all five of these key bankruptcy protections. Thus, unlike ordinary creditors, derivatives and repo counterparties, could, for example, terminate their contract immediately upon a debtor filing bankruptcy, and seize and sell collateral. Proponents of these special exemptions have argued that safe harbors allow counterparties to quickly cancel contracts and enter new hedges (with other counterparties), thus ensuring their financial health and avoiding financial market distress.”
In total, Dr. Michel argued for the repeal of Dodd/Frank and the removal of carve outs for repo and derivative dealers from bankruptcy protection.
But while Dr. Michel argued against Dodd/Frank, Michael Barr, a professor at the University of Michigan, argued that Dodd/Frank provided further protections
“When Lehman Brothers entered into bankruptcy in September 2008, it caused a seismic shock in our financial system. The complicated web of Lehman’s financial obligations left balance sheets worldwide exposed to a cascade of default risk, and contagion spread the risk throughout the financial system. It would be foolish to rely solely on the hope that bankruptcy judges, even if the House-passed bill were to become law, could manage the failure of a financial institution of the size, complexity, and interconnectedness, and cross-border exposures and activities of Lehman, AIG, or the largest U.S. bank holding companies, insurance conglomerates, or investment banks.”
Barr instead argued that the orderly liquidation in Dodd/Frank provides a better path forward.
“Orderly Liquidation has three essential features: First, supervision, planning, and management. Resolution of a failing firm is part of an integrated system of ongoing supervision by the Fed and FDIC, including stress tests, living wills, pre-placed capital and convertible debt. It relies on management of resolution by an expert agency with a large, dedicated and experienced staff. Supervisors, seeing deep financial stress at a firm, can put the firm into resolution, restructure its capital and debt, and create a bridge institution for its ongoing operation—before it is too late.
“Second, the availability of FDIC-provided liquidity in a crisis, backed by the firm’s assets, when private sector lenders are likely to balk. Without that, resolution is a fool’s errand, likely to spark widespread panic. Taxpayers are fully protected by the firm’s collateral and by automatic assessments on the largest financial institutions should such assets prove insufficient.
“Third, global coordination with foreign regulators, based not only on pre-negotiated legal memorandums of understanding, but also war gaming, communications, and, most importantly, the development of a trusted relationship earned over time.”
The arguments in general fell largely along partisan lines, with Republicans largely favoring the Financial Choice Act with Democrats largely opposing it.
“Ending the bureaucratic nightmare that is Dodd/Frank,” said Jeb Hensarling from the State of Texas and the Chairman of the House Financial Services Committee, “and replacing it with simpler capital rules of the Financial CHOICE Act is imperative.”
Maxine Waters from the State of California repeatedly referred to the bill as “The Wrong Choice Act 2.0.”
The Financial Choice Act was passed out of committee late last year but moved no further; however, the dynamics of the legislature with President Trump in charge and Republicans holding both chambers are much more favorable to the bill this time around.